How do interest rate changes implemented by the Fed affect the stock market?

The actions of the Federal Reserve are closely followed by the investment community. Scores of analysts work to interpret the statements issued by the Fed and also attempt to predict any changes to interest rates that the Fed might undertake.

Because of the effect of these expectations, there can be no guarantee about how the market will react to any given interest rate change the Fed chooses to make. However, as a general rule of thumb, when the Fed cuts interest rates, this causes the stock market to go up; when the Fed raises interest rates, this causes the stock market as a whole to go down. (For more insight, read How Interest Rates Affect The Stock Market.)

This is because lower interest rates make for cheaper debt financing, which allows businesses to expand their operations using debt capital at a lower cost. The expansion boosts the economy. Conversely, higher interest rates tend to cool off the economy, which can decrease stock valuations.

However, if expectations differ significantly from the Fed's actions, these generalized reactions need not necessarily apply. For example, if the bulk of the investment community expects the Fed to cut interest rates by 50 basis points at its next meeting, but the Fed only cuts interest rates by 25 basis points, this may actually cause the stock market to decline because expectations of a 50 basis point cut had already been priced in to the market.